VAT adjustment is the way forward

The Greek government’s hope for a political solution and a staff-level agreement on the program review by the end of May is looking increasingly unlikely. To the extent that a piecemeal approach to an agreement is not accepted by the creditors, negotiations may drag on even longer and a way has to be found to bridge temporary funding gaps in early June and beyond to avoid a default. Tangible results on value-added tax (VAT) reform and a couple of other issues could help provide the ground for lengthier negotiations and some form of temporary funding.

In a recent speech at the Economist 19th Roundtable with the Government of Greece, Prime Minister Alexis Tsipras laid out the requirements for a compromise with lenders. First, the primary budget surplus for 2015 and 2016 should be lower than targeted. Second, there should be no new cuts to pensions and wages or other restrictive measures that will return the economy to the spiral of recession. Third, Athens seeks a restructuring of public debt and finally, an investment program, mainly in infrastructure and new technologies.

It is reminded that the second EU/IMF bailout program targeted a primary surplus of 3 percent of GDP against a growth forecast of 2.9 percent in 2015 and a surplus of 4.5 percent of GDP on an even brighter economic outlook next year. According to government sources, the lenders are willing to lower the primary surplus close to or below 1 percent of GDP this year on worsening economic prospects and set the surplus at around 2 percent in 2016.

However, even meeting a much lower surplus at 0.8-1 percent of GDP this year would require additional austerity measures between 3 and 5 billion euros, according to pundits. This is based on GDP growth forecasts ranging between nil and 0.5 percent. It is interesting that the lenders demanded extra austerity measures of 1.7 billion euros last December from the previous coalition government to attain a primary surplus equal to 3 percent of GDP this year.

Moreover, the EU/IMF reportedly refused last fall to accommodate the previous government’s demand that the 2015 primary surplus be set between 2.5 and 2.8 percent of GDP. This indicates that the lenders have softened their stance on the fiscal front since then, taking into account the deteriorating economic situation. The SYRIZA-led government can also claim that its negotiating tactics and its campaign against austerity have yielded fruit since the lenders have accepted one of its major demands. On the other hand, it may have problems explaining to the public why it took more austerity measures than its predecessor to meet a much lower target, if this is finally the case, although its superior communication skills may help overcome that bump at home.

In this respect, we think an agreement on VAT reform is possible. Of course, it will entail some political cost to the current government elected on an anti-austerity platform but it should be weighted against the much greater cost of not reaching an accord. Regardless of the details, such as the new structure encompassing two or three VAT tax rates, it could bring in more revenues and fill a good deal of the estimated fiscal gap on a much lower primary budget target of 0.8 to 1 percent of GDP. This will help pave the way for an agreement on the fiscal front, which, coupled with similar ones on privatizations and bad bank loans, could provide the springboard for a bigger accord, including the other three issues pointed out by the prime minister.

The benefits of reforming the VAT structure should also be seen from another angle. Unfortunately, Greece is consuming much more than it is producing. Total consumption has decreased significantly in absolute numbers during the crisis from 218.5 billion euros in 2009 to 166.4 billion in 2013, 164.4 billion in 2014 and an estimated 162.6 billion this year, according to the European Commission. Even so, it has declined much less as a percentage of GDP since 2009 and remains at very high levels, close to around 89 percent of GDP in 2014.

So, it makes economic sense to rely on VAT to tame consumption spending further, preferably by reducing the imports of consumer goods and services. This could improve the current account balance and boost GDP. The VAT tax is a sales tax and could help this goal so the government will not need to resort to other measures, such as taxing personal income, which creates disincentives for work and hurts labor productivity, to come up with more revenues. Of course, a number of small companies and craftsmen collect the VAT tax from their clients but do not deliver it to the state. So, steps have to be taken to discourage this practice, which amounts to stealing, not just tax evading.

According to opinion polls, the vast majority of the population, around 70 percent, wants to stay in the euro but support for the government’s negotiating tactics has fallen to about 35 percent in May from above 75 percent last February. However, SYRIZA’s popularity remains high, widening its lead from the conservative New Democracy party, partly reflecting the perception among the people that the previous government bowed easily to the demands of the lenders and did not negotiate hard enough. Tsipras also remains very popular and has the political capital to make an “honorable compromise” with the lenders. Starting with an agreement on the new VAT structure could be a good way forward.

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